Investors in a prepaid tuition plan purchase a percentage of a year’s tuition, which will always be worth the same percentage of a year’s tuition. The percentage of a year’s tuition is usually expressed in terms of certificates, credits or units.

Prepaid tuition plans are often promoted as locking in future tuition at current prices. For example, one prepaid tuition plan’s web site states that it offers “Tomorrow’s Tuition at Today’s Prices.” However, most prepaid tuition plans charge a significant premium over current tuition rates. The premium helps compensate for the shortfall between college tuition inflation and investment returns.

Contributions to a prepaid tuition plan are made with after-tax dollars. Earnings within a prepaid tuition plan occur on a tax-deferred basis.

Distributions from a prepaid tuition plan are tax-free if used to pay for qualified education expenses subject to certain additional restrictions. Qualified higher education expenses include tuition, fees, books, supplies, equipment, expenses for special needs services, and, if enrolled on at least a half-time basis, room and board.

The earnings portion of a non-qualified distribution is taxed at the beneficiary’s rate plus a 10 percent tax penalty.

Eligibility

Prepaid plans are state-sponsored programs for saving for future college expenses. Like a Roth IRA, the taxpayer invests after-tax dollars. The earnings accumulate on a tax-deferred basis and may be entirely tax-free if used for qualified higher education expenses. (Educational institutions may also offer their own prepaid tuition plans.)

Generally, either the beneficiary or the account owner must live in the state that offers the prepaid tuition plan. Some states will allow non-residents to invest in the prepaid tuition plan, but the tuition certificates will cover only in-state tuition. If the student does not qualify as a state resident by the time he or she uses the prepaid tuition plan, he or she will be charged the difference between in-state and out-of-state tuition at a public college or university.

Prepaid plans are better than a Roth IRA because some states offer a state income tax deduction or tax credit for all or part of contributions to the state’s prepaid tuition plan. Of the states with prepaid tuition plans, thirteen provide an income tax deduction for contributions to the state’s prepaid tuition plan. These include Alabama, Colorado, Illinois, Maryland, Michigan, Mississippi, New Mexico, Ohio, Pennsylvania, South Carolina, Virginia, West Virginia, Wisconsin. Of these, four states (Colorado, New Mexico, South Carolina and West Virginia) allow a deduction for the full amount of the contribution to the state's prepaid tuition plan and five states (Alabama, Illinois, Michigan, Mississippi, Pennsylvania) have contribution limits that are likely to exceed most annual contributions.

Contributions may come from any individual, including the beneficiary, the beneficiary’s parents, grandparents, aunts, uncles or other relatives, and people unrelated to the beneficiary. Contributions may also come from corporations, trusts and other organizations. Some 501(c)(3) tax exempt charitable organizations award scholarships through a contribution to the student’s prepaid tuition plan.

Contributions to a prepaid tuition plan may be subject to gift taxes, especially if the family makes a lump sum contribution as opposed to regular monthly contributions from birth. Generally, people can contribute up to the annual gift tax exclusion ($14,000 in 2013, 2014 and 2015) to each beneficiary's prepaid tuition plan, twice that for a married couple, without incurring gift taxes. If the contribution exceeds the annual gift tax exclusion, then five-year gift tax averaging would apply. This treats the contribution as having been made ratably over a five-year period beginning with the current tax year. If the contributor dies during the five-year period, only the part of the gift will be treated as completed and, hence, removed from the contributor's estate. The portion of the gift corresponding to periods after the death of the contributor will remain in the contributor's estate.

There is no age limit on contributions or distributions. However, most prepaid tuition plans assume that the parents start making contributions at a particular age and that contributions end when the student reaches the typical age for enrollment in college. In most cases, a prepaid tuition plan is used for undergraduate education.

Contributions must be made in cash. A prepaid tuition plan may not be pledged as security for a loan.

Most prepaid tuition plans are designed to be used to pay for in-state public colleges or universities. In some cases participants may use the prepaid tuition plan for a private non-profit college or an out-of-state public, but will not receive the full tuition cost. Instead they may be limited to the average cost of an in-state public college or to the refund value of the plan. Even if a state’s prepaid tuition plan is limited to public colleges, nothing prevents the family from rolling over the prepaid tuition plan into a 529 college savings plan.

The beneficiary of a prepaid tuition plan may be changed to a member of the family of the current beneficiary. The prepaid tuition plan may be rolled over to another prepaid tuition plan or 529 college savings plan for the same beneficiary or a member of the family of the current beneficiary, but rollovers for the same beneficiary are permitted only once per 12-month period.

Members of the family of the beneficiary include the beneficiary’s spouse, the beneficiary’s son, daughter, stepchild, foster child, adopted child or their descendants, the beneficiary’s brother, sister, stepbrother or stepsister, the beneficiary’s father, mother or any ancestor of the beneficiary’s father or mother, the beneficiary’s stepfather or stepmother, the beneficiary’s nephews, nieces, aunts and uncles, the beneficiary’s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law, the spouse of any of these family members, and first cousins.

Distributions from prepaid tuition plans include both earnings and a return of contributions. Each is deemed to be included proportionately within any distribution. For example, if one third of the refund value of a prepaid tuition plan is from earnings and two thirds from contributions, then one third of any distribution will be assumed to have come from earnings.

The tax treatment of a non-qualified distribution differs according to whether one is considering the part of the distribution that comes from earnings or the part that came from contributions.

The earnings portion of a non-qualified distribution is subject to income tax at the beneficiary’s rate plus a 10 percent tax penalty. Exceptions are made for the 10 percent tax penalty (but not the ordinary income taxes) for distributions made in connection with the beneficiary’s death or disability, because of the receipt of a scholarship, veterans education benefits or employer tuition assistance by the beneficiary, because of the attendance of the beneficiary at a U.S. military academy or because of coordination restrictions with the American Opportunity Tax Credit or Lifetime Learning Tax Credit.

The portion of a distribution that comes from contributions is not taxed.

Financial Aid Impact

If a prepaid tuition plan is owned by a dependent student (custodial account) or a dependent student’s parent, it is reported as though it were a parent asset on the Free Application for Federal Student Aid (FAFSA). This includes prepaid tuition plans that are owned by a stepparent, so long as the stepparent is married to the custodial parent. Distributions from such a prepaid tuition plan are not reported as income on the FAFSA. The asset value of a prepaid tuition plan is the refund value of the plan.

If a prepaid tuition plan is owned by anyone other than the student or parent, it is not reported as an asset on the FAFSA. This includes prepaid tuition plans owned by a grandparent, an aunt or an uncle. (If the student’s parents are divorced, prepaid tuition plans owned by the custodial parent or the custodial parent’s spouse are reported on the FAFSA, but prepaid tuition plans owned by the non-custodial parent are not reported as assets on the FAFSA.) If a prepaid tuition plan is not reported as an asset on the FAFSA, distributions from such a prepaid tuition plan are reported as untaxed income to the beneficiary (the student) on the subsequent year’s FAFSA.

Typically $40,000 to $50,000 of parent assets are sheltered on the FAFSA, based on the age of the older parent. In addition, if parent income is below $50,000 a year and the parents are eligible to file an IRS Form 1040A or 1040EZ, or the family qualifies for certain means-tested federal benefit programs, the family will qualify for the simplified needs test, which disregards all assets. In a worst case scenario the parent assets will be assessed on a bracketed scale, with a top bracket of 5.64 percent.

Untaxed income to the student will reduce eligibility for need-based financial aid by as much as half of the amount of the distribution. This has a much harsher impact on eligibility for need-based aid than a student or parent-owned prepaid tuition plan.

There are, however, a few workarounds if the prepaid tuition plan is owned by someone other than the student or the parent.

One option is to change the account owner to be the parent or the student. Not all states permit this. If the prepaid tuition plan is in a state that doesn’t permit voluntary changes to the account owner, one can rollover the plan into a state plan that permits changes to the account owner. Generally, it is best to wait until after the FAFSA is filed to change the account owner, so that the prepaid tuition plan does not need to be reported as an asset on the FAFSA and that year’s distributions also do not need to be reported on the subsequent year’s FAFSA.

Another option is to wait until after the FAFSA is filed for the student’s senior year in college to take a distribution, when there is no subsequent year’s FAFSA to be affected by the distribution. (It is unclear whether the distribution must be reported as untaxed income if the student files a FAFSA for graduate or professional school.)

The CSS/Financial Aid PROFILE form considers all 529 college savings plans and prepaid tuition plans that name the student as a beneficiary. The PROFILE form also considers 529 plans and prepaid tuition plans that are owned by siblings who are under age 19 and not yet enrolled in college.

Coordination Restrictions

You cannot double dip. You cannot use the same expenses to justify both the exclusion from income for distributions from a prepaid tuition plan and another education tax benefit, such as a tax-free distribution from a 529 college savings plan, the tax-free portion of a qualified scholarship, tax-free distributions from Coverdell education savings accounts or the American Opportunity Tax Credit.

Contributions may be made to both a prepaid tuition plan, 529 college savings plan and Coverdell education savings account for the same beneficiary in the same year.

Income Phaseouts

The exclusion from income for distributions from prepaid tuition plans is not subject to a phaseout on the tax-free treatment of the distributions.

Expiration

The legislation authorizing the exclusion from income for distributions from prepaid tuition plans does not expire.

Economic Growth and Tax Relief Reconciliation Act of 2001, (P.L. 107-16, 6/7/2001), adds option for one or more colleges to create their own prepaid tuition plans in addition to the plans operated by states, substitutes 10% tax penalty for prior provisions regarding penalties for distributions for non-qualified expenses, adds definition of cash and in-kind distributions for qualified higher education expenses, adds coordination restrictions with Hope and Lifetime Learning tax credits, Coverdell education savings accounts (then Education IRAs), adds option to rollover to a different 529 college savings plan or prepaid tuition plan for the same beneficiary once per 12-month period, adds first cousins to the definition of "member of family", modifies limit on room and board, adds special needs services to the list of qualified higher education expenses

Working Families Tax Relief Act of 2004, (P.L. 108-311, 10/4/2004), adds restrictions relating to generation skipping taxes on the change of beneficiary to require the new beneficiary to be the same or higher generation as the old beneficiary

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